Institutional Investors Flashcards
5 Common Characteristics of Institutional Investors
- Scale (Size)
- Long-Term Investment Horizon
- Regulatory Framework
- Governmental Framework
- Principal Agent Issues
IPS of Institutional Investors Should Include
- Mission and Investment Objectives Return and Risk Tolerance
- Discussion of the time horizon and liabilities as that need to be paid off
- Any External Constraints: Legal, regulation, taxation, and accounting
- Asset Allocation Policy: ranges, weights, and asset class benchmarks
- Rebalancing Policy
- Reporting Requirements
Approaches to Asset Allocation
- Norway Model
- Yale Model “Endowment Model”
- Canadian Pension Plan Model
- Liability Driving Investment
Norway Model
- 60% equities and 40% bonds
- Passive allocation to public securities
- Little to no exposures to alternatives
- Tight tracking error limits
- Advantages: Lowest costs and fees, easy for communication
- Disadvantages: Passively managed, no opportunities for outperform the markets
Yale Model
- High allocation to alternatives; around 50%
- Assets are managed externally
- Advantages: Potential to outperform the markets (actively managed)
Disadvantages:
* Difficult for a smaller institutions to implement
* Higher fees and costs
* Difficult for larger management due to limits of capacity
Canadian Pension Plan Model
- High Allocation to Alternatives
- Significant amounts of active management
- The assets will be managed internally and due diligence
- Ability to outperform the market
- Disadvantages: More expensive and difficult to manage
Liability Driven Model
- Maximize the surplus
- Management limits the volatility of the surplus
- Taken into account the liability
- Longevity risks is difficult to hedge (lifespans)
Defined Benefit Plan (DB)
- Less prevent, traditionally set up a legal entity with a trust
- Must hire an actuary to determine the benefits due
- Assume risks if not enough funds
- Surplus: Any additional can be used to pay for other expenses such as an actuary
- Longevity Risks
- Plan sponsor makes contributions to plan
- Comparing FMV of assets by the projected benefit obligation “PBO” (PVDBO IFRS)
- Gives the economic status of the plan, must be placed on the balance sheet
Considerations that Drive the Risks Tolerance for a DB Plan
- Plans funded status
- Sponsors Financial Status
- The size of the plan compared to the sponsor
- Common risk exposure
- Any provisions for early retirement “lump sum distributions:
- Workforce characteristics
- Correlations between the sponsor and plan assets
Liquidity Needs of a DB Plan
Liquidity needs are generally higher if:
* The workforce is older
* Larger proportion of relived lives in the plan that are receiving benefits
* Lower the Funded Status Plan
* If there is a provision to withdraw or switch from the plan
Investment Objective of a DB Plan
Primary Objective: Achieve a target rate of return over a long-term investment horizon to maintain a level of risk consistent with their contracted liabilities
Secondary Objective: Might not be for every plan. Could be to minimize the cash contributions that the plans sponsor has to make, in present value terms PBO > Plan assets
Discount Rate Change of a DB Plan
Higher Discount Rate: Reduces the present value of the liabilities (PBO) and would reduce the need for sponsor contributions to the plan (raises the funded status)
Lower Discount Rate: Increases the present value of the liabilities (PBO) and would increase the need for sponsor contributions to the plan (lowers the funded status)
Defined Contribution (DC) Plans
- Employee saves for retirement and the employer could match an amount
- Very little accounting by the employer
- Performance risk is born by the employee
- Metrics of outperformance any kind is to a passive benchmark or default option
Sovereign Wealth Funds Categories
Investment funds owned by a government there are 5-broad categories:
* Budget Stabilization Funds
* Development Funds
* Savings funds
* Reserve Funds
* Pension Reserve Funds
Sovereign Wealth Funds - External Constraints
Establish by law, gives the mission structure to avoid political influence they need
* High Quality Governance
* Independent
* Transparency
* Accountability
Santiago Principal
Best principal framework that address the external constraints